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Adjusting for Innovation

If research and development is an investment, why not treat it as such?

Question: Is research and development an operating expense or an investment? I'm guessing most of you would say it's an investment. Then explain to me why, as explained in a recent Forbes' article, GAAP treats R&D as an annual expense, not an investment to be capitalized and depreciated.

Let's think for a moment. Is research spending necessary for Intel(NASDAQ:INTC) to manufacture microprocessors or Cisco(NASDAQ:CSCO) to produce routers? Only in the sense that prior R&D spending benefits current product, implying that current R&D spending will benefit future production. Quoting Forrest Gump, "I may not be a smart man," but in this sense, R&D seems more like an investment than an operating expense.

The Forbes authors came up with a novel approach to deal with this conundrum. They suggest adjusting earnings by adding back R&D expenses, arriving at what they call innovation-adjusted earnings. I like this idea, but would take it a step further. Assuming R&D is an investment, you could add it back to operating cash flow, leading to what I'm calling Innovation-Adjusted Free Cash Flow (IAFCF). Here's the simple formula:

IAFCF = (operating cash flow + R&D expense) - capital expenditures

I think of free cash flow as a decision point, where the company asks, "What should I do with this cash?" The options are numerous, including big dividends, share buybacks, paying down debt, making acquisitions, or funding R&D.

How might this affect valuation of some leading technology companies? In fiscal 2004, Microsoft(NASDAQ:MSFT) generated $14.6 billion in operating cash, had $7.8 billion in R&D expenses, and $1.1 billion in capital expenditures. Under the strict definition, free cash flow was $13.5 billion, or about $1.24 per share. Using our adjusted formula...

Essentially, Microsoft is punished $0.71 per share today for R&D expenses that may not generate sales for years to come. Other companies are forced to underreport free cash flow as well. IBM's(NYSE:IBM) 2003 free cash flow jumps from $5.79 to $8.67 per share, adjusted for innovation, while Oracle(NASDAQ:ORCL) generated $0.83 of IAFCF in fiscal 2004 vs. $0.58 of traditional free cash flow.

By no means is IAFCF a perfect tool, but looking at R&D as an investment might help explain the relatively high multiples technology companies command. While not necessarily cheap, tech companies don't appear quite so overvalued when you adjust for investment in innovation.